Thursday, December 30, 2010

US Facing Debt Scarcity?

Ron Robins, Founder & Analyst - Investing for the Soul

If US consumers believe it difficult to borrow now, just wait! In the next few years credit conditions are likely to go back seventy years when private debt was difficult to obtain. Most Americans intuitively believe there is too much debt at every level of society. But the economic and political vested interests do not want them worried about that. They want to give them credit to infinity to keep this economic mess from imploding. The US Federal Reserve’s new round of quantitative easing (QE2) is clear evidence of that. However, Americans are right about their inordinate debt load, and future economic conditions are likely to create a severe debt scarcity.

The principal reasons for the coming debt scarcity are that ‘debt saturation’—where total income cannot support total debt—has arrived, say some analysts; also, the growing understanding that adding new debt may not increase GDP—it could decrease it; and that the banks and financial system are a train wreck in waiting, eventually being forced to mark their assets to market, thus creating for them massive asset write-downs and strangling their lending ability.

The realization that debt saturation has arrived will not surprise many people. But understanding that new debt can decrease economic activity might surprise them. And the numbers illustrate this possibility. In Nathan’s Economic Edge, Nathan states, “in the third quarter of 2009 each dollar of debt added produced NEGATIVE 15 cents of productivity, and at the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP!”

In fact Nathan also shows that for decades, each new dollar of debt produces less and less in return, from a return of close to $0.90 in the mid 1960s to about $0.20 by 2007. One explanation for this is that as societal debt increased it focused disproportionately on consumption rather than productive enterprise, whose return appears greater.

On the subject of consumption, the renowned economist David Rosenberg in The Globe & Mail on August 16 stated that “U.S. household debt-income ratio peaked in the first quarter of 2008 at 136 per cent. The ratio currently sits at 126 per cent, but the pre-2001 norm was 70 per cent. To get down to this normalized ratio again, debt would have to be reduced by about $6-trillion. So far, nearly $600-billion of bad household debt has been destroyed.” This data reaffirms Americans growing aversion to debt, that debt has become too onerous, and is suggestive of debt saturation.

Replacing declining consumer debt is the exponential growth of US government debt. For 2009 and 2010, the combined US government’s fiscal deficits required or require borrowing an extra $2.7 trillion or so. Yet with all that spending—combined with about $2 trillion of ‘money printing’ from the US Federal Reserve (the Fed)—it created only around $1 trillion in increased economic growth!

One may argue that the phenomenal US government borrowings will provide returns far into the future and that the present low economic returns are due to not funding areas with potentially better returns. Some economists say that spending on infrastructure and education provides the best returns. However, with economists such as Nobel Laureate Paul Krugman and numerous others predicting huge continuing deficits for years ahead, and with a Japan-like slump in economic activity, the odds are likely that any new borrowed dollar will continue to provide only poor returns for years to come.

A further, major reason for the coming debt scarcity will be the tremendously impaired financial condition of the banks. The values assigned to many bank assets are fictional according to numerous experts. QE2 is about many things but one of them is aimed at delaying the potential for implosion of the banking system. In 2009, the Financial Accounting Standards Board (FASB) caved in to government and banking industry lobbyists to allow many bank assets to be ‘marked to fantasy’ and not ‘marked to market.’

This viewpoint is best expressed by highly respected Associate Professor William Black (and formerly a senior regulator who nailed the banks during the savings and loan debacle) and Professor L. Randall Wray, who wrote an article on October 22 in The Huffington Post, entitled, “Foreclose on the Foreclosure Fraudsters, Part 1: Put Bank of America in Receivership.” They wrote that, “FASB's new rules allowed the banks (and the Fed, which has taken over a trillion dollars in toxic mortgages as wholly inadequate collateral) to refuse to recognize hundreds of billions of dollars of losses. This accounting scam produces enormous fictional ‘income’ and ‘capital’ at the banks.”

However, the Federal Reserve may be realizing that it might not have been such a good idea to buy some of these ‘toxic’ securities. Bloomberg reported on October 19 that, “citing alleged failures by Countrywide to service loans properly… Pacific Investment Management Co., BlackRock Inc. and the Federal Reserve Bank of New York are seeking to force Bank of America Corp. to repurchase soured mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit, people familiar with the matter said.”

Also, on November 2, CNBC reported that Citigroup could be liable for huge amounts of toxic security buy-backs as well. “If all four mortgage acquisition channels turn out to be equally as defective… Citi's liability for repurchases could soar to about $100 billion dollars at a 60 per cent defect rate - and to around $133 billion dollars at an 80 per cent defect rate.”

Clearly, such numbers are staggering. These, as well as many other banks and financial entities, could collapse. Politically, in the present circumstances, it would be difficult for the US government to provide massive new funds to support the financial system. Therefore, it will be up to the Fed to decide what to do.

If the Fed prints ever increasing amounts of new money to try to moderate the financial collapse, hyperinflation could be the result. If it does not print massive amounts of new money, a deflationary depression could be born.

In high inflationary or hyperinflationary conditions, few will want to lend as they get paid back in dollars that are declining very rapidly in value. In a deflationary episode, lending is reduced due to huge loan losses. Therefore, during either, and/or after such events, debt scarcity will be in full force.

Data indicates that American consumers do not want to increase their debt. Debt saturation is occurring, and with it a declining return on each borrowed dollar—even for the US government. Most significantly, the banks and the financial system will probably soon experience a new round of massive real estate related losses and subsequent financial institutions’ bankruptcies. Thus, a new major financial crisis will likely soon engulf America, greatly impairing its lending facilities and creating a severe scarcity of debt.